The stock is up today after releasing good earnings with EPS of $1.69 vs consensus $1.61, and thanks to disclosing more information around their PBM business. Their 3Q18 EPS guidance is below consensus, but the focus is on the Aetna transaction closing in the coming 2-3 months. The Aetna deal is expected to close in Q3 or early Q4, pointing to higher confidence the deal will go through. A “substantial” number of states have approved the deal. MinuteClinic is introducing video visits through the CVS Pharmacy app 24 hours/day, leveraging Teledoc’s technology platform.
2Q18 results summary:
· Revenue +2.2%: PBM +2.8% (claims volume & brand inflation), Retail/LTC +5.7% (pharmacy SSS +8.3% and front store SSS -1%), MinuteClinic revenue +4.2%
· Gross margin +25bps
· Adjusted operating margin +10bps
· Adjusted EPS +27%, thanks to lower tax rate, and share gains in retail/LTC segment, and a $0.05 beat from better profitability in its PBM segment
· Free cash flow $2.5B +60%
Management provided some transparency around their PBM business, which has been under scrutiny for the past year:
· 98% of rebates passed-through to clients (this was closer to 90% a year ago)
· Retained rebates represent only 3% of their 2018 annual adjusted EPS (~$300M)
· PBM used by health plans to obtain better discounts and cost savings, but also to improve adherence to drugs
The potential removal of the safe harbor for rebates could lead to a net pricing model (rather than the current gross-net bubble we’re experiencing now). The impact on the PBM industry is unclear. The management team also clarified that their Medicare Part D covered under its SilverScript prescription drug plan business (covering 13.4M lives) works with annual bids. Yesterday the Center for Medicare & Medicaid Services allowed Medicare Advantage plans to use PBM tools for their Part D drugs, a testament of the need for PBM in negotiating drug prices.
Also announced today is a $3.9B goodwill impairment charge in their Long Term Care business. Industry wide financial challenges lead to a lower growth than anticipated 3 years ago when they acquired the business. To improve this business, a new leadership team has been put in place, with goals to:
· Enhance service level to improve client retention
· System-wide cost improvement effort, especially to service the skilled Nursing Facility channel
· Improve solutions to the Assisted and Independent Living markets: grow penetration rate from 50% to 70%
Valuation: we are maintaining our price target of $90.FCF yield of ~9% is very attractive given the potential for growth but reflects the risks around Aetna’s integration and PBM pressure for 2019.
Thesis on CVS
- Market leader: largest pharmacy benefit manager (PBM) in the US. This gives CVS scale advantage and negotiating power with pharma companies to obtain better drug pricing discounts. Also the largest US pharmacy retailer, giving it more touch points with consumers/patients. Finally, market share leader in long-term care pharmacy sector thanks to its Omnicare acquisition.
- Stable and predictable top line and margin profile. CVS benefits from an ageing population in increasing needs of prescription drugs.
- shareholder friendly, offering a 7% shareholder yield (5% share repurchase + 2.6% dividend yield)
$CVS.US
[tag CVS]
Julie S. Praline
Director, Equity Analyst
Direct: 617.226.0025
Fax: 617.523.8118
Crestwood Advisors
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Boston, MA 02109
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